Mundell–Fleming without the LM curve: the exogenous interest rate in an open economy

Abstract

In this paper we evaluate critically the popular Mundell-Fleming model from the standpoint the exogenous interest rate heterodox approach. We criticize the assumptions of exogenous money supply, "perfect" international capital markets and inelastic exchange rate expectations. We show that in a more realistic framework none of the main results of the Mundell-Fleming model on the relative effectiveness of fiscal and monetary policies are valid, either in floating and fixed exchange rate regimes. We conclude that ,within certain very asymmetric bounds, the central bank has the power to determine the domestic interest rate exogenously even in open economy with free capital mobility and that there is no automatic market mechanism to ensure the automatic adjustment of the interest rate and exchange rate to sustainable levels.

Interest Rates and Exchange Rate Relationship in BRIC-T Countries

“…As a result, country's international reserves decrease or increa-se, this leads to a decrease (increase) in the money supply. Serrano and Summa (2011)state that the increase (decrease) in money supply decreases (increases) the domestic interest. In the Mundell-Fleming model with floating exchange rates, it is assumed that the exchange rate appreciates when the domestic interest rate is above the international level and vice versa.…”

“…However, it is unlikely to accept the changes in interest rate policy to be purely exogenous to stabilize the exchange rates because the monetary authorities in many countries resort to high interest rate policy when the currency is under pressure and low interest rate policy when the currency is in normal levels. In other words, decline in the value of the exchange rate may themselves prompt monetary authorities to raise domestic interest rates (Serrano and Summa, 2011).…”

Distribution and Conflict Inflation in Brazil under Inflation Targeting, 1999–2014

“…Thus, an actual change in the nominal exchange rate usually tends to change the expected exchange rate in the same direction, amplifying the process of appreciation or depreciation. (For a theoretical explanation for this relation, see Serrano and Summa 2015b; Summa 2016)…”

“… 6 Notice that we are saying that the interest rate is exogenous, in the sense that the central bank sets the basic interest rate (and thus to influence also the expectations of long term rate) and there is no market mechanism capable of changing this rate (Serrano and Summa 2013), even in an open economy (Lavoie 2000, 2001, 2014; Serrano and Summa 2015b). …”

Old Cycles and New Vulnerabilities: Financial Deregulation and the Argentine Crisis

“…Given the impact of the exchange rate on inflation (measured by the degree of pass-through), monetary authorities are usually more vigilant of substantial depreciations than appreciations Financial Deregulation and the Argentine Crisis 603 (Agenor and Pereira da Silva, 2019;Ebeke and Azangue, 2015;Ostry et al, 2012). One of the consequences of this asymmetry is the tendency to offer higher interest rates, as mentioned above (Kaltenbrunner and Painceira, 2017;Serrano and Summa, 2015). Furthermore, IT regimes go hand in hand with deregulations in the financial account of the balance of payments, particularly with regard to outflow controls, allowing greater flexibility for capital flows in either direction.…”